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					Chapter 24         Power Notes
       Capital Investment Analysis


              Learning Objectives
    1. Nature of Capital Investment Analysis
    2. Methods of Evaluating Capital
       Investment Proposals
    3. Factors That Complicate Capital
       Investment Analysis
    4. Capital Rationing
                                        C24



                                               C24 - 1
Chapter 24               Power Notes
         Capital Investment Analysis


  Slide #       Power Note Topics
     3      •   Nature of Capital Investment Decisions
     7      •   Average Rate of Return; Cash Payback
    15      •   The Time Value of Money
    26      •   Present Value Analysis
    29      •   Other Considerations


    Note: To select a topic, type the slide # and press Enter.



                                                                 C24 - 2
Nature of Capital Investment Decisions


1. Management plans, evaluates, and controls
   investments in fixed assets.
2. Capital investments involve a long-term
   commitment of funds.
3. Investments must earn a reasonable rate of
   return.
4. Should include a plan for encouraging and
   rewarding employees for submitting proposals.




                                                   C24 - 3
Methods of Evaluating Capital Investments


   Methods that do not use present values
   Average rate of return method
   Cash payback method

   Methods that use present values
   Net present value method
   Internal rate of return method




                                            C24 - 4
            Average Rate of Return
Advantages:                Disadvantages:
Easy to calculate          Ignores cash flows
Considers accounting       Ignores the time
income (often used to      value of money
evaluate managers)


                Cash Payback
Advantages:                Disadvantages:
Considers cash flows       Ignores profitability
Shows when funds           (accounting income)
are available for          Ignores cash flows after
reinvestment               the payback period


                                                   C24 - 5
              Net Present Value
Advantages:                Disadvantages:
Considers cash flows       Assumes that cash
and the time value of      received can be
money                      reinvested at the rate
                           of return


            Internal Rate of Return
Advantages:                Disadvantages:
Considers cash flows       Requires complex
and the time value of      calculations
money                      Assumes that cash can
Ability to compare         be reinvested at the
projects of unequal size   internal rate of return

                                                    C24 - 6
      Average Rate of Return Method

Assumptions:
Machine cost            $500,000
Expected useful life     4 years
Residual value             none
Expected total income   $200,000

                Estimated Average
 Average Rate     Annual Income
  of Return   =
                Average Investment




                                      C24 - 7
      Average Rate of Return Method

Assumptions:
Machine cost            $500,000
Expected useful life     4 years
Residual value             none
Expected total income   $200,000

                Estimated Average
 Average Rate     Annual Income
  of Return   =
                Average Investment

 Average Rate    $200,000 / 4 yrs.
  of Return   =                     = 20%
                ($500,000 + $0) / 2



                                            C24 - 8
       Average Rate of Return Method

Assumptions:              Proposal A Proposal B
Average annual income       $30,000   $36,000
Average investment         $120,000 $180,000
Average rate of return

                   Estimated Average
    Average Rate     Annual Income
     of Return   =
                   Average Investment

What is the average rate of return for each proposal?




                                                        C24 - 9
      Average Rate of Return Method

Assumptions:             Proposal A Proposal B
Average annual income      $30,000   $36,000
Average investment        $120,000 $180,000
Average rate of return        25%       20%

     This method emphasizes accounting
     income which is commonly used in
     evaluating management performance.




                                                 C24 - 10
            Cash Payback Method

Assumptions:
Investment cost           $200,000
Expected useful life       8 years
Expected annual net
  cash flows (equal)       $40,000
      Cash        Total Investment
     Payback =          Annual Net
      Period           Cash Inflows


            What is the cash payback period?




                                               C24 - 11
            Cash Payback Method

Assumptions:
Investment cost           $200,000
Expected useful life       8 years
Expected annual net
  cash flows (equal)       $40,000
      Cash        Total Investment
     Payback =          Annual Net
      Period           Cash Inflows

     Cash          $200,000
    Payback =                    = 5 years
                       $40,000
     Period


                                             C24 - 12
           Cash Payback Method

Assumptions:
                 Net Cash  Cumulative
                   Flow   Net Cash Flow
        Year 1   $ 60,000    $ 60,000
        Year 2     80,000     140,000
        Year 3    105,000     245,000
        Year 4    155,000     400,000
        Year 5    100,000     500,000
        Year 6     90,000     590,000

      If the proposed investment is $400,000,
      what is the payback period?



                                                C24 - 13
           Cash Payback Method

Assumptions:
                 Net Cash  Cumulative
                   Flow   Net Cash Flow
        Year 1   $ 60,000    $ 60,000
        Year 2     80,000     140,000
        Year 3    105,000     245,000
        Year 4    155,000     400,000
        Year 5    100,000     500,000
        Year 6     90,000     590,000

      If the proposed investment is $450,000,
      what is the payback period?



                                                C24 - 14
The Time Value of Money – Future Value
The time value of money concept is used in many
business decisions. This concept is an important
consideration in capital investment analysis.

Present
 Value        $1,000

    What is the future value of $1,000 invested
    today (present value) at 8% per year?


 Future
              $ ????
 Value




                                                   C24 - 15
The Time Value of Money – Future Value
The time value of money concept is used in many
business decisions. This concept is an important
consideration in capital investment analysis.

Present
 Value        $1,000

    What is the future value of $1,000 invested
    today (present value) at 8% per year?


 Future                = $1,000 + ($1,000 x 8%)
              $1,080   = $1,000 x 108% or 1.08
 Value




                                                   C24 - 16
The Time Value of Money – Present Value
The time value of money concept is used in many
business decisions. This concept is an important
consideration in capital investment analysis.

Present
 Value        $ ????


   What is the present value of $1,000 to be
   received one year from today at 8% per year?

 Future
              $1,000
 Value




                                                   C24 - 17
The Time Value of Money – Present Value
The time value of money concept is used in many
business decisions. This concept is an important
consideration in capital investment analysis.

Present
 Value       $ 925.93 = $1,000 / 108% or 1.08


   What is the present value of $1,000 to be
   received one year from today at 8% per year?

 Future
              $1,000
 Value




                                                   C24 - 18
          Calculating Present Values
Present values can be determined using present value
tables, mathematical formulas, calculators or computers.

    Present Value of $1 with Compound Interest
      PV Table
  Period    6%           Calculator
      1    .9434     = $1.0000 / 1.06

     One dollar at the end of one
     period at 6% per period is equal
     to $.9434 today (present value).




                                                     C24 - 19
          Calculating Present Values
Present values can be determined using present value
tables, mathematical formulas, calculators or computers.

    Present Value of $1 with Compound Interest
      PV Table
  Period    6%           Calculator
      1    .9434     = $1.0000 / 1.06
      2    .8900     = $ .9434 / 1.06
     One dollar at the end of two
     periods at 6% per period is equal
     to $.8900 today (present value).
     To use the value from the prior
     period as the starting point, don’t
     clear your calculator.
                                                     C24 - 20
          Calculating Present Values
Present values can be determined using present value
tables, mathematical formulas, calculators or computers.

    Present Value of $1 with Compound Interest
      PV Table
  Period    6%           Calculator
      1    .9434     = $1.0000 / 1.06
      2    .8900     = $ .9434 / 1.06
      3    .8396     = $ .8900 / 1.06

     One dollar at the end of three
     periods at 6% per period is equal
     to $.8396 today (present value).


                                                     C24 - 21
           Calculating Present Values
Present values can be determined using present value
tables, mathematical formulas, calculators or computers.

     Present Value of $1 with Compound Interest
       PV Table
   Period    6%            Calculator
      1     .9434      = $1.0000 / 1.06
      2     .8900      = $ .9434 / 1.06
      3     .8396      = $ .8900 / 1.06
      4     .7921      = $ .8396 / 1.06
       5     a calculator,$learn to /use constant division.
When using .7432       =     .7921 1.06
                       and .7432 / first
You will then enter $1 = $ 1.06 the1.06 time, pressing
       6    .7050
only the equal (=) key for each successive answer.

                                                         C24 - 22
 Calculating Present Values of Annuities
Annuities represent a series of equal amounts to be
paid or received in the future over equal periods.

        Present Value of $1 — Annuity of 1$
     PV Table       Annuity     Calculation
 Period    6%         6%      Sum of Periods
    1      .9434     .9434    = Period 1
    2      .8900    1.8334    = Periods 1–2
          .8396     2.6730    = to be
    3 The PV of an annuity of $1Periods 1–3
           .7921     year for = Periods 1–4
    4 received each 3.4651 two years is
                               of the PV of
    5 $1.8334. This is the sum = Periods 1–5
           .7432     4.2124
      the two amounts for periods 1 and 2.
          4.2124


                                                      C24 - 23
 Calculating Present Values of Annuities
Annuities represent a series of equal amounts to be
paid or received in the future over equal periods.

        Present Value of $1 — Annuity of 1$
     PV Table       Annuity     Calculation
 Period    6%         6%      Sum of Periods
    1      .9434     .9434    = Period 1
    2      .8900    1.8334    = Periods 1–2
    3      .8396    2.6730    = Periods 1–3
          .7921     3.4651    = to be
    4 The PV of an annuity of $1Periods 1–4
           .7432     year for = Periods is
    5 received each 4.2124 three years 1–5
      $2.6730. This is the sum of the PV of
          4.2124
      the three amounts for periods 1–3.

                                                      C24 - 24
 Calculating Present Values of Annuities
Annuities represent a series of equal amounts to be
paid or received in the future over equal periods.

          Present Value of $1 — Annuity of 1$
     PV Table         Annuity     Calculation
 Period    6%           6%      Sum of Periods
    1        .9434     .9434    = Period 1
    2        .8900    1.8334    = Periods 1–2
    3        .8396    2.6730    = Periods 1–3
    4        .7921    3.4651    = Periods 1–4
    5        .7473    4.2124    = Periods 1–5
  Total     4.2124


                                                      C24 - 25
            Present Value Method

Assumptions:    Investment           $200,000
                Useful life            5 years
                Residual value           none
                Minimum rate of return    10%
         Cash Flow                    Present Value
Year 1 $70,000 / 1.10     (1 time)    = $ 63,636.36
Year 2    60,000 / 1.10   (2 times)   = 49,586.78
Year 3    50,000 / 1.10   (3 times)   = 37,565.74
Year 4    40,000 / 1.10   (4 times)   = 27,320.54
Year 5    40,000 / 1.10   (5 times)   = 24,836.85
Total present value                    $202,946.27
Less investment                         200,000.00
Net present value                      $ 2,946.27
Present value index                          1.015

                                                      C24 - 26
            Present Value Method

Assumptions:                   Proposals
                          A        B       C
Total present value   $107,000 $86,400 $93,600
Total investment       100,000   80,000  90,000
Net present value     $ 7,000 $ 6,400 $ 3,600
Present value index      1.07       1.08      1.04

      What is the meaning of an index over 1.0?




                                                     C24 - 27
         Internal Rate of Return Method
The internal rate of return method uses the net cash
flows to determine the rate of return expected from the
proposal. The following approaches may be used:
     Trial and Error
   Assume a rate of return and calculate the present
   value. Modify the rate of return and calculate a new
   present value. Continue until the present value
   approximates the investment cost.
     Computer Function
   Use a computer function to calculate exactly the
   expected rate of return.



                                                      C24 - 28
        Qualitative Considerations

Improvements that increase competitiveness and
quality are difficult to quantify. The following
qualitative factors are important considerations.
1. Improve product quality?
2. Reduce defects and manufacturing cycle time?
3. Increase manufacturing flexibility?
4. Reduce inventories and need for inspection?
5. Eliminate non-value-added activities?




                                                    C24 - 29
      The Capital Rationing Process


1. Identify potential projects.
2. Eliminate projects that do not meet minimum
   cash payback or average rate of return
   expectations.
3. Evaluate the remaining projects, using present
   value methods.
4. Consider the qualitative benefits of all projects.
5. Rank the projects and allocate available funds.




                                                        C24 - 30
Chapter 24            Power Notes
       Capital Investment Analysis




   This is the last slide in Chapter 24.
     Note: To see the topic slide, type 2 and press Enter.




                                                             C24 - 31

				
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